Rethinking a common assumption about retirement spending

"If you aren't careful, inflation will ravage your retirement income. You might end up having to eat dogfood when you get old."

Over the years, I've heard many variations of this dire warning from investment advisers, annuity salespeople and financial consultants. They create a lot of fear in retirees, who then might end up hoarding their savings, saving them for the proverbial rainy day.

But a new study from BlackRock sheds some light on how much retirees spend over their lifetimes, and it might allow them to feel comfortable about spending more money during their retirement. It also calls into question the need to inflation-protect every bit of your retirement income.

The BlackRock study analyzed survey data from the Health and Retirement Study (HRS) which follows groups of people as they age through the years -- a so-called longitudinal analysis. When trying to determine whether retirees increase or decrease spending throughout their lifetime, this technique is superior to "cohort" analyses that compare only current spending among current retirees in different age groups.

Many planners and analysts predict a U-shaped pattern of spending as retirees age, based on cohort analyses described above. They assume that new retirees will spend substantial amounts on travel, hobbies and interests. Then their spending will decline when they're less able to enjoy these activities. According to this assumed pattern, spending on medical and long-term care then subsequently increases significantly in retirees' frail and final years.

After examining the HRS data that followed the median spending habits of retirees for up to 18 years, the BlackRock study didn't find this U-shaped pattern of spending. Instead, median spending (adjusted for inflation) declined very slightly over the 18-year period for the three groups of retirees studied (lowest wealth, medium wealth and highest wealth). 

BlackRock found that the vast majority of retirees managed to keep their spending under their income. In addition, the majority of them didn't experience a drastic spike in spending on medical expenses during the two years before they died. Instead, the study found that out-of-pocket spending on medical expenses didn't jump until the 95th percentile of costs among those surveyed.

You can protect yourself from outliving your money by using your retirement savings as a monthly retirement income generator, rather than a pot of money you hoard or freely spend. Set up this generator to last the rest of your life, no matter how long you live. There are many methods for setting up a retirement income generator, ranging from annuities with insurance companies to investing your savings and using a systematic withdrawal plan to calculate the monthly paycheck.

You can then feel comfortable spending this monthly paycheck without worrying about outliving it.

Why are BlackRock's findings important? It takes about 25 percent more saving to generate a retirement paycheck that increases for inflation, compared to a paycheck that's fixed in dollar terms. If you don't need to inflation-protect the retirement paycheck that's generated by your savings, you can spend more money today.

The BlackRock study shows that Social Security -- which increases by the rate of change in the Consumer Price Index (CPI) each year -- might provide all the inflation-protected income that many retirees need. For the lowest-wealth retirees in the study, Social Security delivers 80 percent of their total retirement income. It delivers 61 percent of total retirement income for the medium-wealth retirees and 56 percent for the highest-wealth retirees.

Investment advisers often dismiss the value of traditional pension benefits or fixed-payout annuities because they aren't indexed for inflation. However, the BlackRock study provides some support for using these very user-friendly retirement income generators. If inflation erodes the value of a fixed paycheck, retirees have shown a resilient ability to make ends meet by reducing their "wants" and focusing their spending on "needs."

Retirees and their advisers might do best to build a diversified portfolio of retirement income that starts with optimizing inflation-protected Social Security benefits. Such a portfolio would then carefully allocate retirement savings between systematic withdrawal plans invested in low-cost index funds with low-cost payout annuities.

Of course, in spite of the BlackRock findings, some retirees might still feel safer by reining in their spending throughout retirement. In the end, your retirement spending is a personal choice that takes into account your preferences and the need to be able to sleep at night. A carefully designed retirement income portfolio can help you feel safe about spending your hard-earned savings and enjoying your retirement.